Wednesday, March 5

This Remedy is as bad as the problem!

This remedy is about as bad as the problem!
Bernancke suggests banks write off loan principal to save foreclosure

During a speech yesterday at the annual convention of Independent Community Bankers in Orlando, Florida, Chm. Bernancke gave a speech about 'Reducing Preventable Mortgage Foreclosures'. He mentioned that over the past year and a half, delinquency rates on riskier mortgage loans have steadily climbed.

"... weak underwriting might not have produced widespread payment problems had house prices continued to rise at the rapid pace seen earlier in the decade. Rising prices provided leveraged borrowers with significant increases in home equity and, consequently, with greater financial flexibility. Instead, as you know, house prices are now falling in many parts of the country. The resulting decline in equity reduces both the ability and the financial incentive of stressed borrowers to remain in their homes. Indeed, historically, borrowers with little or no equity have been substantially more likely than others to fall behind in their payments. The large number of outstanding mortgages with negative amortization features may exacerbate this problem."

The banker\lenders job is to measure risk, mitigate risk, and recirculate the money. One factor used to mitigate risk is limiting loan to value (LTV). In a real estate market that for years did nothing but climb and climb, it may have become easy for the banker\lender to exercise more flexibility when it came to LTV, assuming that the housing market would not crash.

One of the work out strategies that the Chairman discussed was refinancing the delinquent mortgage. He recognized that in many cases this is not possible. Two major challenges to refinancing are (1) tightening credit standards, and, (2) LTV Limitations.

"In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent. For the lender or servicer, working out a loan makes economic sense if the net present value (NPV) of the payments under a loss-mitigation strategy exceeds the NPV of payments that would be received in foreclosure. Loss mitigation is made more attractive by the fact that foreclosure costs are often substantial. Historically, the foreclosure process has usually taken from a few months up to a year and a half, depending on state law and whether the borrower files for bankruptcy. The losses to the lender include the missed mortgage payments during that period, taxes, legal and administrative fees, real estate owned (REO) sales commissions, and maintenance expenses. Additional losses arise from the reduction in value associated with repossessed properties, particularly if they are unoccupied for some period."

Mr. Bernancke further discussed the Hope Now project, where lenders have modified loan terms and reduced interest rates to make payments more affordable. But, he explained, this isn't really happening.

What he suggested as a remedy would further poison our economic recovery. Yes, it would stave off foreclosure, but how will it motivate those who aren't willing to or otherwise cannot make the payments, whether out of poor financial skills or lack of income? Moreover,it would wreak further havoc on Wall Street.

In order to cut losses, Chm. Bernancke suggests that banks write off the amount of the loan that is 'unsecured'; the balance of the loan that exceeds the property value.

If banks were to subscribe to this kind of thinking, how would investors react? How many more billions of dollars in losses would this amount to? How would this pan out?

First, housing values would further deteriorate, credit would become even harder to come by. Credit standards would be even more stringent, and interest rates and fees would skyrocket in an effort to immediately recover these losses.

I understand the 'why' behind Chm. Bernanckes suggestion, but I'm not clear on how it could possibly make a bad situation any better. I see it as another blow to our economy should it ever happen.

Read the transcript of the entire speech here

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